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Money and Banking

Functions Of Money

In an economy, money is a crucial element that facilitates transactions and economic activity. Before the invention of money, economies relied on the barter system, which involved the direct exchange of goods and services for other goods and services. However, the barter system had significant drawbacks.

Drawbacks of the Barter System

To overcome these problems, money was evolved. Money is defined as anything that is generally acceptable as a medium of exchange and also acts as a measure of value, a store of value, and a standard for deferred payments.

Functions of Money

The functions of money are broadly classified into two categories: Primary and Secondary functions.

1. Primary Functions

These are the most fundamental functions of money in an economy.

2. Secondary Functions

These functions are derived from the primary functions.

3. Contingent Functions

Some economists also point out contingent functions, which are incidental or modern functions of money.


Demand For Money And Supply Of Money

In a modern economy, the interaction between the demand for money and the supply of money determines key macroeconomic variables like the interest rate. Understanding these two components is fundamental to understanding monetary policy.

Demand for money refers to the desire of people to hold their wealth in the form of liquid cash rather than in other assets like bonds or property. People demand money for various reasons, primarily for conducting transactions and as a precaution against uncertainty (as discussed later in detail).

Supply of money refers to the total stock of money in circulation in an economy at a particular point in time. This includes currency held by the public and demand deposits in commercial banks. The supply of money is primarily controlled by the central bank of the country.

Central Bank

A central bank is an apex institution that controls, regulates, and supervises the monetary and banking system of a country. In India, the central bank is the Reserve Bank of India (RBI), which was established on April 1, 1935.

Functions of the Central Bank (RBI)

  1. Issuer of Currency (Bank of Issue): The central bank has the sole authority to issue currency notes in the country. This ensures uniformity in the nation's currency. In India, the RBI has the sole right to issue currency notes of all denominations except one-rupee notes and coins, which are issued by the Ministry of Finance, Government of India. However, the entire currency is circulated through the RBI. This function is also known as the 'currency authority' function.
  2. Banker, Agent, and Advisor to the Government:
    • As a Banker: The RBI manages the accounts of the central and state governments. It accepts receipts and makes payments for the government and carries out its exchange and remittance operations. It also provides short-term credit to the government.
    • As an Agent: The RBI manages the public debt on behalf of the government.
    • As an Advisor: The RBI advises the government on all monetary and economic policy matters.
  3. Banker's Bank and Supervisor: The RBI acts as the bank for all commercial banks in the country. Commercial banks are required to keep a certain portion of their deposits with the RBI (Cash Reserve Ratio). The RBI also provides clearing house facilities for settling claims between different commercial banks. As a supervisor, it regulates and supervises the functioning of commercial banks to ensure they operate on sound banking principles.
  4. Lender of Last Resort: When commercial banks are unable to meet their financial obligations from other sources, they can approach the central bank for loans and advances as a last resort. The RBI provides this assistance to protect the financial structure of the country from collapse by ensuring the solvency of commercial banks.
  5. Custodian of Foreign Exchange Reserves: The RBI acts as the custodian of the country's stock of gold and foreign exchange reserves. This function enables the central bank to manage the external value of the currency and handle foreign exchange crises. It manages the exchange rate to ensure stability in the foreign exchange market.
  6. Controller of Money Supply and Credit: This is a crucial function. The RBI is responsible for controlling the supply of money and credit in the economy to achieve price stability and economic growth. It uses various quantitative and qualitative tools (discussed in section I4) to regulate the amount of credit created by commercial banks.

Commercial Banks

A commercial bank is a financial institution that accepts deposits from the public and gives loans for the purposes of consumption and investment. Commercial banks are the heart of the financial system and play a vital role in the economy. Examples in India include the State Bank of India (SBI), Punjab National Bank (PNB), HDFC Bank, ICICI Bank, etc.

Functions of Commercial Banks

The functions of commercial banks can be divided into two main categories:

  1. Primary Functions:
    • Accepting Deposits: Banks accept deposits from the public in various forms, such as:
      • Current Account Deposits: Repayable on demand, usually maintained by businesses. They offer cheque facilities but no interest.
      • Savings Account Deposits: Combine features of both current and fixed deposits. They offer cheque facilities and also pay a small amount of interest.
      • Fixed or Time Deposits: Deposited for a fixed period. They offer a higher rate of interest but do not offer cheque facilities.
    • Advancing Loans: The deposits received by banks are used to give loans to individuals and businesses. The interest charged on loans is the main source of income for banks. Loans are provided in various forms like cash credit, overdraft, and short-term, medium-term, and long-term loans.
  2. Secondary Functions:
    • Overdraft Facility: Allows a current account holder to withdraw more than their account balance, up to an agreed limit.
    • Discounting Bills of Exchange: A bank can provide cash to the holder of a bill of exchange before its maturity date by deducting a commission (discount).
    • Agency Functions: Banks act as agents for their customers by performing functions like transferring funds, collecting cheques, making periodic payments (like insurance premiums), etc.
    • General Utility Functions: These include providing locker facilities, issuing traveller's cheques, dealing in foreign exchange, etc.

A key role of commercial banks in the context of money supply is credit creation. While they do not print money, their lending process effectively creates new deposits, thereby expanding the overall money supply in the economy. This process is discussed next.


Money Creation By Banking System

Money creation, or credit creation, is one of the most important activities of commercial banks. Through this process, commercial banks are able to create money by a multiple of their initial deposits. The process of money creation is based on two key assumptions:

  1. The entire commercial banking system is treated as a single unit, which we can call 'Banks'.
  2. All receipts and payments in the economy are routed through the banks. That is, anyone who receives a payment deposits it in a bank, and anyone who makes a payment does so by writing a cheque.

The capacity of banks to create credit depends on the Legal Reserve Ratio (LRR). LRR is the minimum ratio of deposits legally required to be kept as cash by the banks. This is determined by the central bank. LRR has two components:

For simplicity in our explanation, we will combine these into a single LRR. Let us assume the LRR is 20% or 0.2.

Balance Sheet Of A Fictional Bank

A balance sheet is a statement of the assets and liabilities of a bank.

Let's trace how money is created using a fictional bank's balance sheet. Suppose an individual makes an initial deposit of ₹1,000. The bank's balance sheet looks like this:

Liabilities Assets
Deposit: ₹1,000 Reserves (Cash): ₹1,000

Now, the bank knows from experience that not all depositors will withdraw their money at the same time. Assuming an LRR of 20%, the bank is required to keep only ₹200 (20% of ₹1,000) as reserves and is free to lend the remaining ₹800. Let's say the bank lends this ₹800 to a borrower. The borrower will likely spend this money, and the person who receives it will deposit it back into the banking system (based on our assumption). This starts Round 1 of credit creation.

After the loan is made, the bank's balance sheet becomes:

Liabilities Assets
Deposit: ₹1,000

Reserves: ₹200

Loan: ₹800

The ₹800 that was lent out is now deposited by someone else into the banking system, creating a new deposit. This is where money creation happens. The total deposits in the system are now ₹1,000 (initial) + ₹800 (new) = ₹1,800. The bank now has a new deposit of ₹800. It will keep 20% of this (₹160) as a reserve and lend out the remaining ₹640. This process continues.

Limits To Credit Creation And Money Multiplier

The process of credit creation will continue until the new deposits become zero. In each round, the amount of the loan is 80% (1 - LRR) of the previous deposit. This is a geometric progression.

Round Deposits (₹) Loans (₹) Reserves (LRR = 20%) (₹)
Initial 1,000.00 800.00 200.00
1 800.00 640.00 160.00
2 640.00 512.00 128.00
... ... ... ...
Total 5,000.00 4,000.00 1,000.00

The total deposit creation can be calculated using the concept of the Money Multiplier.

Derivation of the Money Multiplier

The money multiplier is the number by which the total deposits can increase due to a given change in deposits. It is the reciprocal of the Legal Reserve Ratio (LRR).

Total Deposits = Initial Deposit + Deposit in Round 1 + Deposit in Round 2 + ...

$ \Delta D = \text{Initial Deposit} + \text{Initial Deposit} \times (1 - LRR) + \text{Initial Deposit} \times (1 - LRR)^2 + ... $

This is a geometric series with the first term $ a = \text{Initial Deposit} $ and common ratio $ r = (1 - LRR) $.

The sum of an infinite geometric series is $ S = a / (1 - r) $.

$ \text{Total Deposits} = \frac{\text{Initial Deposit}}{1 - (1 - LRR)} = \frac{\text{Initial Deposit}}{LRR} $

From this, we get the formula for the money multiplier:

$$ \text{Money Multiplier} = \frac{\text{Total Deposits}}{\text{Initial Deposit}} = \frac{1}{LRR} $$

In our example, with an initial deposit of ₹1,000 and LRR = 20% (or 0.2):

Money Multiplier = $ \frac{1}{0.2} = 5 $

Total Deposit Creation = Initial Deposit × Money Multiplier

Total Deposit Creation = ₹1,000 × 5 = ₹5,000

Thus, an initial deposit of ₹1,000 leads to a total deposit creation of ₹5,000. The total reserves will equal the initial deposit (₹1,000), and the total loans created will be ₹4,000. The limit to credit creation is therefore determined by the initial deposit amount and the LRR set by the central bank. A higher LRR leads to a lower money multiplier and less credit creation, while a lower LRR leads to a higher money multiplier and more credit creation.


Policy Tools To Control Money Supply

The central bank (RBI in India) uses several tools to control the money supply and credit in the economy. These tools are collectively known as Monetary Policy. The objective is to maintain price stability and ensure an adequate flow of credit to productive sectors of the economy. These tools can be broadly classified into quantitative and qualitative instruments.

Quantitative Instruments

These instruments influence the overall volume of credit in the economy and affect all sectors without discrimination.

  1. Bank Rate (or Discount Rate): The bank rate is the rate at which the central bank lends money to commercial banks for their long-term needs. An increase in the bank rate makes borrowing from the central bank more expensive for commercial banks. This forces them to increase their own lending rates, which discourages borrowing by the public and reduces the money supply. Conversely, a decrease in the bank rate makes borrowing cheaper, encouraging credit expansion.
  2. Repo Rate: This is the rate at which the central bank lends money to commercial banks for their short-term needs against the collateral of government securities. It is the primary tool for day-to-day liquidity management. An increase in the repo rate contracts the money supply, while a decrease expands it. This is currently the main policy rate in India.
  3. Reverse Repo Rate: This is the rate at which the central bank borrows money from commercial banks. It is the rate at which commercial banks can park their surplus funds with the central bank. An increase in the reverse repo rate incentivizes commercial banks to park more funds with the RBI, thus reducing the funds available for lending and contracting the money supply.
  4. Open Market Operations (OMO): OMO refers to the buying and selling of government securities (bonds) by the central bank in the open market.
    • To decrease the money supply (contractionary policy), the RBI sells government securities. This sucks out liquidity from the market as buyers (commercial banks) pay the RBI, reducing their capacity to lend.
    • To increase the money supply (expansionary policy), the RBI buys government securities. This injects liquidity into the system as the RBI pays the sellers, increasing their capacity to lend.
  5. Legal Reserve Ratios (LRR):
    • Cash Reserve Ratio (CRR): As defined earlier, it is the fraction of deposits that banks must keep with the RBI. An increase in CRR reduces the excess reserves of commercial banks, curbing their lending capacity and contracting the money supply. A decrease in CRR has the opposite effect.
    • Statutory Liquidity Ratio (SLR): The fraction of deposits banks must maintain with themselves in specified liquid assets. An increase in SLR locks up more of the banks' funds, reducing their ability to create credit. A decrease in SLR frees up funds for lending.

Qualitative Instruments

These instruments are used to regulate the flow of credit to specific sectors of the economy. They are selective in nature.

  1. Margin Requirements: The margin is the difference between the market value of the security offered for a loan and the amount of the loan granted. For example, if the margin is set at 30% for a security worth ₹1,00,000, the bank can only lend a maximum of ₹70,000. By increasing the margin, the RBI can discourage borrowing for specific purposes (e.g., speculative activities). By decreasing the margin, it can encourage credit flow to certain priority sectors.
  2. Rationing of Credit: This involves fixing credit quotas for different business activities. The RBI can fix a maximum limit on loans that can be granted to a particular sector or for specific purposes. This is used to check speculative activities or channel credit towards priority areas.
  3. Moral Suasion: This is a combination of persuasion and pressure that the central bank applies to other banks to get them to follow its policy directives. The RBI holds regular meetings with commercial banks to persuade them to act in a manner that is in line with the broader economic objectives of the country. For example, it might persuade them to lend more to the agricultural sector during a specific period.

Demand And Supply For Money : A Detailed Discussion

The demand for money is often referred to as liquidity preference, a term popularized by John Maynard Keynes. It explains why individuals and businesses choose to hold a part of their assets in the form of money (which earns no interest) instead of other assets like bonds or stocks that can yield returns. Keynes identified three main motives for holding money.

The Transaction Motive

This is the most straightforward reason for demanding money. People need to hold cash to carry out their day-to-day transactions. There is a time lag between the receipt of income and its expenditure. For example, a person might receive a salary on the first of the month but will have expenses throughout the month. To bridge this gap, they need to hold some money.

The transaction demand for money ($M_d^T$) is directly proportional to the level of income (Y) and the general price level (P). A higher income or a higher price level means people will need more money to finance their transactions.

$$ M_d^T = f(Y, P) $$

Generally, the transaction demand is considered to be interest-inelastic, meaning it does not change significantly with changes in the interest rate, as people need a certain amount of cash for daily life regardless of the potential returns from other assets.

The Precautionary Motive

This is closely related to the transaction motive. People hold some extra cash as a precaution against unforeseen events or emergencies, such as a sudden illness, an accident, or unexpected travel. This precautionary demand for money also depends positively on the level of income. A wealthier individual is likely to hold more money for precautionary purposes.

The Speculative Motive

This is the most distinctive part of Keynes's theory. The speculative demand for money arises from the desire to make a profit by "speculating" on the future movement of interest rates and bond prices. Individuals can hold their wealth either in the form of money (which is perfectly liquid but earns no interest) or in financial assets like bonds (which are less liquid but earn interest).

The Inverse Relationship between Bond Price and Interest Rate

There is an inverse relationship between the market rate of interest and the price of a bond. A bond typically has a fixed coupon payment (interest payment) and a face value.

Let's say a perpetual bond has a face value of ₹1,000 and pays a fixed coupon of ₹50 per year. The yield or effective interest rate on this bond is its coupon payment divided by its market price.

$$ \text{Interest Rate} (r) = \frac{\text{Fixed Coupon Payment}}{\text{Market Price of Bond}} $$

If the market interest rate for similar assets is 5%, the price of this bond will be $ \frac{₹50}{0.05} = ₹1,000 $. Now, if the market interest rate rises to 10%, a newly issued ₹1,000 bond would pay ₹100. To compete, the price of our old bond must fall. Its new price will be $ \frac{₹50}{0.10} = ₹500 $. Conversely, if the market interest rate falls to 2.5%, the price of our bond will rise to $ \frac{₹50}{0.025} = ₹2,000 $.

Conclusion: When the interest rate is high, bond prices are low. When the interest rate is low, bond prices are high.

Speculative Demand

Speculators use this relationship to make gains.

Therefore, the speculative demand for money ($M_d^S$) is inversely related to the rate of interest (r).

$$ M_d^S = f(r) $$

The total demand for money ($M_d$) is the sum of the transaction (including precautionary) demand and the speculative demand.

$$ M_d = M_d^T + M_d^S $$

A graph showing the Liquidity Preference Curve. The y-axis represents the rate of interest, and the x-axis represents the quantity of money demanded. The curve is downward sloping, indicating an inverse relationship. At a very low interest rate, the curve becomes horizontal, which is the liquidity trap.

The Supply Of Money : Various Measures

The supply of money is a stock concept. The RBI publishes four alternative measures of money supply, denoted by M1, M2, M3, and M4.

The components of these measures are:

Measure Formula / Components Description
M1 C + DD + OD This is the most liquid measure of money supply, also known as 'Narrow Money'. The assets included are all highly liquid and can be used directly for transactions.
M2 M1 + Savings deposits with Post Office saving banks This measure is broader than M1. It includes post office savings, which are less liquid than demand deposits in banks.
M3 M1 + Net time deposits of the commercial banks This is the most commonly used measure of money supply, also known as 'Broad Money'. It includes time deposits (like Fixed Deposits), which are less liquid than demand deposits but are a major part of the banking system. It serves as the aggregate monetary resource of the country.
M4 M3 + Total deposits with Post Office savings organisations (excluding National Savings Certificates) This is the least liquid measure of the four. It includes all types of post office deposits.

In terms of liquidity: M1 > M2 > M3 > M4.


Demonetisation

Demonetisation is the act of stripping a currency unit of its status as legal tender. It occurs whenever there is a change of national currency. The current form or forms of money are pulled from circulation and retired, often to be replaced with new notes or coins. Sometimes, a country completely replaces the old currency with a new currency.

In the Indian context, demonetisation has been a significant policy tool used on a few occasions. The most recent and impactful instance was on November 8, 2016.

The 2016 Indian Demonetisation

On November 8, 2016, the Government of India announced the demonetisation of all ₹500 and ₹1,000 banknotes of the Mahatma Gandhi Series. At the time, these two denominations accounted for approximately 86% of the total currency in circulation by value. The government also announced the issuance of new ₹500 and ₹2,000 banknotes in exchange for the demonetised banknotes.

Stated Aims and Objectives

The government stated several objectives for this drastic measure:

  1. Tackling Black Money: A primary goal was to make unaccounted cash holdings (black money) worthless. It was assumed that individuals holding large amounts of illicit cash would be unable to deposit it in banks without explaining the source, thus flushing it out of the system.
  2. Combating Counterfeit Currency: The move was intended to invalidate fake currency notes that were being used for illicit activities, including terror financing. It was believed that high-value fake notes were in wide circulation.
  3. Curbing Terror Financing: By invalidating the existing high-value notes, the government aimed to disrupt the financial networks of terrorist and extremist groups that relied on cash transactions.
  4. Promoting Digitalisation and Formalisation: A long-term goal was to push the Indian economy towards more formal and digital modes of payment. With a sudden cash crunch, people were encouraged to adopt digital payment methods like mobile wallets, UPI, and card payments. This would increase transparency and bring more economic activity into the formal, taxable domain.

Process and Impact

The public was given a window of about 50 days (until December 30, 2016) to deposit their old ₹500 and ₹1,000 notes into their bank accounts. There were long queues outside banks and ATMs, and a severe cash shortage affected the economy for several months.

Impacts of Demonetisation:

The long-term effects and overall success of the demonetisation exercise remain a subject of debate among economists and policymakers.


Summary

This unit provides a comprehensive overview of money and the banking system, crucial components of any modern economy. We began by understanding the necessity of money by examining the inefficiencies of the barter system, primarily the problem of the double coincidence of wants. Money solves this by serving four key functions: a medium of exchange, a measure of value, a store of value, and a standard of deferred payment.

The core of the monetary system consists of the Central Bank (the RBI in India) and Commercial Banks. The Central Bank acts as the apex monetary authority, responsible for issuing currency, managing the government's finances, supervising the banking system, and, most importantly, controlling the money supply. Commercial banks are the primary financial intermediaries, accepting deposits and advancing loans. A key function of commercial banks is money creation. Through the mechanism of the money multiplier, which is the reciprocal of the Legal Reserve Ratio (LRR), banks can expand their deposits and create credit far in excess of their initial reserves.

To manage the economy, the Central Bank employs various monetary policy tools to control the supply of money. These are categorized as quantitative tools (Bank Rate, Repo Rate, Open Market Operations, CRR, SLR) that affect the overall credit volume, and qualitative tools (Margin Requirements, Moral Suasion) that direct credit to specific sectors.

The demand for money, or liquidity preference, stems from three motives: the transaction motive (for daily expenses), the precautionary motive (for emergencies), and the speculative motive (to profit from changes in interest rates and bond prices). The supply of money is measured by the RBI in four aggregates: M1, M2, M3, and M4, which vary in their degree of liquidity.

We also examined significant policy events like demonetisation in India, its objectives of tackling black money and promoting digitalisation, and its mixed impacts on the economy. Furthermore, we explored the different forms of money, including modern currency and bank deposits, and the role of banks in providing loans, which are vital for economic activity. The credit system is divided into a formal sector (banks, cooperatives) supervised by the RBI and an informal sector (moneylenders). Finally, we discussed the role of Self-Help Groups (SHGs) as an innovative mechanism to provide credit to the poor, especially in rural areas, thereby promoting financial inclusion and empowerment.


Key Concepts


Money And Credit

Money and credit are two of the most fundamental concepts in economics, often described as the "lifeblood" of an economy. While they are closely related, they are distinct concepts.

Money, as we've established, is an asset that people are generally willing to accept in exchange for goods and services or for payment of debts. Its primary role is to act as a medium of exchange, making transactions smoother and more efficient than in a barter economy. It provides a common measure of value, allowing us to price everything in terms of a single unit (like the Indian Rupee, ₹).

Credit, on the other hand, refers to an agreement in which a lender supplies a borrower with money, goods, or services in return for the promise of future payment. Credit essentially allows people to use future income today. When you take a loan from a bank to buy a car, you are using credit. The bank provides you with money now, and you promise to repay it over a period of time in the future, along with interest.

The Interrelationship

The relationship between money and credit is symbiotic.

In summary, while money is the asset used to settle transactions, credit is the mechanism that allows for borrowing and lending. The banking system is the critical institution that links the two, transforming monetary deposits into credit for the economy.


Money As A Medium Of Exchange

The most fundamental function of money is to serve as a medium of exchange. To appreciate this role, one must first consider the alternative: a world without money, which relies on the barter system.

The Problem: Double Coincidence of Wants

In a barter system, exchange is direct: goods are traded for other goods. For this to work, a 'double coincidence of wants' is necessary. This means that what one person wants to sell must be exactly what another person wants to buy, and vice-versa, at the same time and place.

Example 1. A shoe manufacturer wants to sell shoes and buy wheat. Under the barter system, he must find a farmer who not only has surplus wheat to sell but also is in need of new shoes. If the farmer wants clothes, not shoes, no exchange can take place between the shoe manufacturer and the farmer. The shoemaker would then have to first find a cloth weaver who wants shoes, trade shoes for cloth, and then find a farmer who wants cloth in exchange for wheat. This process is incredibly inefficient, time-consuming, and restricts the scope of trade.

The barter system thus involves high transaction costs—the time and effort required to find a suitable trading partner.

The Solution: Money

Money solves the problem of double coincidence of wants by acting as an intermediary in the exchange process. It separates the act of selling from the act of buying.

With money:

  1. The shoe manufacturer can sell his shoes to anyone who wants them, in exchange for money.
  2. He can then use that money to buy wheat from any farmer who is selling it, regardless of whether that farmer needs shoes or not.

Money is generally acceptable, meaning everyone in the economy trusts that it can be used to buy any good or service they might need. This general acceptability is the core characteristic that allows money to function as a medium of exchange. By eliminating the need for a double coincidence of wants, money drastically reduces transaction costs, encourages specialisation, and facilitates a much larger volume of trade, which is essential for economic growth and development.


Modern Forms Of Money

The money used in earlier times consisted of objects with intrinsic value, like grains, cattle (commodity money), or precious metals like gold and silver coins (metallic money). Modern forms of money, however, have no intrinsic value of their own. They are accepted as money because they are authorised by the government of the country. This is known as fiat money. The two main modern forms of money are currency and demand deposits.

Currency

Modern currency consists of paper notes and coins. In India, the Reserve Bank of India (RBI) issues currency notes on behalf of the central government. As per Indian law, no other individual or organisation is allowed to issue currency. The rupee (₹) is the legally recognised medium of exchange in India and cannot be refused in settling transactions. This gives it the status of legal tender.

While the RBI issues most banknotes (₹2 and above), the one-rupee note and all coins are issued by the Ministry of Finance, Government of India. However, all currency is put into circulation only through the RBI.

These notes and coins are valuable not because of the paper or metal they are made of, but because they carry a promise from the central bank and are backed by the authority of the government.

Deposits With Banks

The other major form in which people hold money is as deposits with banks. People deposit their extra cash in banks, which keep the money safe and pay an amount as interest on the deposits. Since these deposits can be withdrawn by the depositor whenever they demand, they are called demand deposits.

Demand deposits are considered a form of money for a crucial reason: they are widely accepted as a means of payment. They offer the essential characteristic of money—the facility of being a medium of exchange. The payment can be made through a cheque or, more commonly today, through digital means like debit cards, net banking, or UPI, all of which are linked to these bank deposits.

In fact, in a modern economy, the total value of demand deposits far exceeds the total value of physical currency. The sum of currency held by the public and demand deposits in banks constitutes the most liquid and basic measure of money supply (M1).

Cheque Payments

A cheque is a paper instrument that instructs a bank to pay a specific sum of money from a person's account to the person in whose name the cheque has been issued. For a payment to be made through a cheque, the payer, who has an account with the bank, fills out a cheque for a specific amount.

How a Cheque Works

  1. The Payer: A person (e.g., Mr. Sharma) needs to pay another person (e.g., Ms. Gupta) ₹10,000. Mr. Sharma has an account at SBI.
  2. Writing the Cheque: Mr. Sharma writes a cheque. This involves writing Ms. Gupta's name, the amount in figures (₹10,000) and words (Ten Thousand Rupees Only), the date, and signing it.
  3. The Payee: Ms. Gupta receives the cheque. She can either deposit this cheque in her own bank account (say, HDFC Bank) or, if it is a 'bearer' cheque, cash it at an SBI branch.
  4. Clearing: If she deposits it, HDFC Bank will send the cheque for clearing. The clearing house (managed by RBI) will process the payment, debiting ₹10,000 from Mr. Sharma's SBI account and crediting it to Ms. Gupta's HDFC account.

This system allows for large transactions to be settled without the use of physical cash, making it a safe and convenient method of payment. Cheques are a direct application of demand deposits functioning as money.

A sample image of a bank cheque. It shows fields for Payee's name, amount in words and figures, date, account number, and a space for the signature. The bank's name and branch details are also printed.

Loan Activities Of Banks

Commercial banks act as crucial intermediaries in the financial system. Their core business model revolves around accepting deposits from those who have surplus funds (savers) and lending these funds to those who need them (borrowers). This process is central to the economic activity of a country.

The Mechanism of Lending

The story of bank loans begins with deposits. As we've seen, people deposit their money in banks for safety and to earn interest. However, banks do not keep all of this money idle in their vaults. Based on their historical experience, banks know that on any given day, only a small fraction of depositors will come to withdraw cash. This allows them to use the majority of the deposits for lending purposes.

Banks keep only a small proportion of their deposits as cash reserves. This proportion is partly determined by their own assessment and partly by the legal requirements set by the central bank (the CRR and SLR). The rest of the money, which is a large portion of the total deposits, is used to extend loans.

Example 1. Suppose a bank has total deposits of ₹100 crore. The RBI has set a Legal Reserve Ratio (LRR) of 20%. This means the bank must keep ₹20 crore as reserves. The remaining ₹80 crore is available for the bank to lend to individuals and businesses for various purposes like buying a home, starting a business, or purchasing a car.

The Bank's Source of Income: The Spread

Banks charge a higher rate of interest on loans than what they offer on deposits. This difference between the lending rate and the deposit rate is called the 'interest rate spread' or 'net interest margin'. This spread is the main source of income for commercial banks.

For instance:

The profit earned from this spread is used to cover the bank's operational costs (salaries, rent, etc.), and the rest is its profit.

By channeling savings into investment and consumption, the loan activities of banks play a vital role in keeping the wheels of the economy moving. They provide the necessary finance for businesses to grow, for families to buy homes, and for individuals to meet their financial needs, thereby stimulating economic growth.


Formal Sector Credit In India

Credit sources in India can be broadly divided into two categories: the formal sector and the informal sector.

Formal Sector Credit includes loans from banks and cooperative societies. The functioning of formal sector lenders is supervised by the Reserve Bank of India (RBI). The RBI sets rules and regulations to ensure that banks not only make a profit but also serve a social objective. For example, the RBI requires banks to maintain a minimum cash balance (CRR, SLR) and also mandates that a certain proportion of their lending goes to 'priority sectors' like agriculture, small-scale industries, and education. The interest rates charged by formal sector lenders are regulated and are generally much lower than those in the informal sector.

Informal Sector Credit includes loans from moneylenders, traders, employers, relatives, and friends. There is no organization that supervises the credit activities of lenders in the informal sector. They can lend at whatever interest rate they choose. There are no rules or regulations to protect the borrower. Consequently, the rates of interest charged are often exorbitant, and lenders may use unfair means to get their money back.

Formal And Informal Credit: Who Gets What?

The availability and use of formal and informal credit are not uniform across all sections of society in India. There is a significant disparity based on economic status.

A pie chart or bar graph showing the sources of credit for rural households in India. It shows that rich households get a majority of their credit from formal sources (banks, co-ops), while poor households rely heavily on informal sources (moneylenders).

Analysis of Credit Distribution

Why the Disparity?

  1. Collateral Requirement: Banks and cooperatives usually demand collateral (an asset like land, property, or vehicle) as security against loans. Since many poor people do not have any assets to offer as collateral, they are unable to get loans from formal sources.
  2. Documentation: Getting a bank loan requires extensive documentation, such as proof of income, identity, and address. Many people in the informal sector lack the necessary papers.
  3. Transaction Costs: The process of getting a loan from a bank can be time-consuming and may involve incidental costs. In contrast, informal loans from a local moneylender are quick and require little to no paperwork.

This heavy dependence on high-cost informal credit often traps poor borrowers in a debt-trap, where the loan repayment amount, including the high interest, can exceed their income, forcing them to take another loan just to make the repayment. Therefore, it is crucial to expand the reach of cheap and affordable formal sector credit, especially in rural areas, to promote equitable development and reduce poverty.


Self-Help Groups For The Poor

One of the major reasons for the limited access of the rural poor to formal bank credit is the lack of collateral. To overcome this problem, a novel approach to providing credit to the poor has gained prominence in recent years: the formation of Self-Help Groups (SHGs).

An SHG is a small, informal association of people from similar socio-economic backgrounds who come together to find ways to improve their living conditions. It is a powerful tool for financial inclusion, poverty alleviation, and women's empowerment, particularly in rural India.

How Self-Help Groups Work

The basic idea behind an SHG is to build a collective financial resource by pooling together small, regular savings from its members.

  1. Formation and Savings: A typical SHG consists of 15-20 members, usually women from the same neighbourhood or village. They meet regularly (e.g., weekly or monthly) and contribute a small, fixed amount of savings, which can be as low as ₹25 to ₹100 or more, depending on their capacity.
  2. Internal Lending: This pooled saving becomes the group's common fund. Members can take small loans from this fund to meet their needs. The group decides on the purpose, amount, interest rate, and repayment schedule for these loans. The interest rates are typically low, but still higher than what a bank would offer, which helps the group's fund to grow.
  3. Building a Track Record: The key feature of an SHG is its emphasis on regular meetings and timely repayment of loans. Since all members are from the same community, there is strong peer pressure to ensure that loans are repaid. This fosters a culture of financial discipline.
  4. Linking with Banks: If an SHG is regular in its savings and repayments for a period of one or two years, it becomes eligible for a bank loan. The bank lends to the group as a whole, and the loan amount is often several times their total savings. The bank does not demand any collateral from the individual members because the loan is given against the group's track record and collective responsibility. This is known as group-based lending.
  5. Decision Making: The group is responsible for the repayment of the bank loan. Decisions regarding the use of the loan amount—who gets a loan, for what purpose, and how much—are taken by the group members themselves. This participatory and democratic process empowers the members.

Advantages of SHGs

In conclusion, Self-Help Groups have emerged as a vital building block of the microfinance movement in India, successfully linking the formal banking sector with the rural poor and fostering economic and social development from the ground up.